Proposed revisions to the rules pertaining to auctions of Receiver General term deposits (discussion paper)
On 18 July 2000, the government and Bank of Canada made public a discussion paper concerning the management of the federal government's cash balances. The paper outlined the current framework and proposed changes, intended to increase competition and to strengthen the management of risks, in particular the credit risks involved in the investment of these funds. The government welcomed responses on all aspects of these proposals and the issues related to implementation.
The letters listed in this section are reproduced as submitted by their respective authors, and have not been edited or proofread by the Bank of Canada. They are intended for reference only, and should not be cited or distributed elsewhere.
The letters are published in their original language only.
Cash & Collateral Management
Bank of Montreal
Since meeting with you and Michael Keenan in the spring, Bank of Montreal remains generally supportive of the government's desire to strengthen the management and risk framework outlined in the discussion paper. BMO however, does have a number of concerns.
With respect to operational matters, we outlined a number of issues during our meeting together.
Additionally, I have contributed to, and support the forthcoming industry response from the Cash Managers. BMO would like to stress the concerns highlighted over collateral and liquidity.
I look forward to participating in future industry or institutional dialogues you may choose to complete your objectives.
Cash Managers Sub-Committee, CBA
Recently the Cash Managers sub-committee of the CBA met to discuss operational matters arising from the above noted discussion paper. While the committee generally supports the government's risk reduction objective, we do have concerns as it relates to the amount of collateral required to support this proposal and liquidity and settlement issues impacting both LVTS and DCS.
For the current year to date, outstanding Receiver General balances have averaged $12.5 billion. Based on uncollateralized lines suggested in the discussion paper, approximately $8-10 billion of the existing deposit program would be collateralized under this proposal. Much of the required collateral will be in the form of federal government bonds and treasury bills as collective NHA MBS pools of this size is not practical. We feel this is a significant increase to collateral levels and costs across LVTS and auction participants. In order to meet collateral needs in such an environment, members will need to further manage competing proprietary requirements for liquid securities. Even with the government's objective to significantly reduce cash balances through an increased debt buy-back program, this proposal will see significant increases in operating collateral levels. This comes at a time when activities such as CLSB will increase the demand for "just in case" liquidity to handle unexpected peaks and time-sensitive needs. On a general collateral matter, we understand the central bank continues to review the list of collateral acceptable for pledging. We look forward to the results of this work and the opportunity for discussion of any changes as they will significantly effect overall collateral management.
Member institutions are subject to asset pledging restrictions. While the Bank Act permits pledging to the central bank, specific approval from the Office of the Superintendent of Financial Institutions for pledging assets to the Government of Canada may be required. Members are reviewing this proposal with in-house counsel.
The discussion paper requested that members consider as to whether collateral pledged on a standing basis would be beneficial from an operational perspective. While standing collateral may ease settlement activities, members question the economics of encumbering collateral on an on-going basis to support potential auction winnings. We would also need to understand the ability to mobilize any securities not required to secure any winnings.
The discussion paper provides a policy perspective for the proposed changes. However, it does not establish an operational framework. The cash managers have attempted to summarize below some of our operational questions and concerns.
In today's environment, a direct LVTS participant receives morning auction net winnings by 1:00 pm. Under the proposed environment; the morning auction will settle in DCS similar to repo activities. To move cash winnings from DCS to LVTS prior to DCS close (after 4pm), members will be required to move excess funds from their funds account in DCS through the central bank to LVTS. This assumes that excess balances are available in DCS to allow this movement to occur. If not, this will result in liquidity being "locked" in DCS and therefore would be unavailable to support LVTS payment activity until late in the LVTS cycle (approximately 5 pm). The impact of this "trap" of auction balances in DCS is heightened on large tax remittance days. In these instances, the morning auction can be significantly larger on the strength of that day's tax receipts. An LVTS participant may desire to utilize auctions winnings in LVTS (or similarly need LVTS collateral) to support the tax remittances due by 3pm and be unable to do so. Similar liquidity issues may be seen on days with larger net federal debt maturities (e.g. September 1, 2000). Larger uncollateralized auction lines and/or larger T2 LVTS bilateral lines would reduce this potential liquidity drain problem.
Specific questions on the morning auction operation include:
1. Will settlement and collateralization be on a gross or net basis?
2. Will a specific deadline be in place for settlement (e.g. 1 pm) or will regular DCS settlement hours be used (4pm)?
3. How will settlement failures be handled? If gross settlement is used, will members have flexibility to settle maturities before the deadline in order to receive back pledged securities?
4. Will there be a minimum size on a given piece of collateral that can be pledged?
5. Will substitutions be allowed? If so, will there be any charge for substitutions?
The afternoon auction is utilized by the Bank of Canada to neutralize federal government cash flows for the purposes of monetary policy. The cash managers believe that participation in this auction should be limited to LVTS participants due to the nature of the auction and the impact it has on settlement balances across LVTS participants. Since this auction occurs late in the day, the discussion paper suggests securities moving free in DCS with funds flowing directly in LVTS. In relation to other DCS settlements this process is referred to as a "cycle 9". The use of Cycle 9 re-introduces settlement risk as the process is not a risk free delivery vs. payment exercise. One of the counterparties (or their agent) must undertake brief settlement risk as the payment and "free" delivery of the secunties cannot be made simultaneously. This raises the question of which counterparty undertakes the settlement risk. Non-direct DCS auction participants will have to make special arrangements with their DCS agent. As a general rule, the industry attempts to settle all transactions within the operating hours of DCS and discourages settlements after DCS payment exchange. "Cycle 9" transactions cannot settle until after payment exchange for DCS is complete. This occurs at approximately 4:45 to 5 pm each day. To support use of DCS to settle afternoon auction activities members will need to ensure adequate staff are available each day for any potential winnings.
A strongly preferred operational alternative for the afternoon auction would be to make the entire auction uncollateralized.
Specific questions on the afternoon auction operation include:
1. Assuming the afternoon auction requires collateralization (after lines are exhausted), will maturities settle in the same manner as winnings? That is, a member will have to make an LVTS payment for the maturity obligation, but the collateral lodged against the deposit will not be released in DCS until after LVTS funds are repaid. If so, double collateralization, or a nano-second problem will occur. An alternative would be for afternoon auction maturities to settle completely in DCS similar to the morning auction. Would this settlement process be an option the government would consider? If so, would settlement occur at a specific time? Will members have flexibility on the timeframe for maturity settlement?
2. Most of the questions asked for the morning auction apply to the afternoon auction as well.
The cash managers committee recognizes that the proposed uncollateralized lines are inclusive of "total holdings". We wish to understand further how the bidding process will function. The following example provides a scenario for discussion:
|Tranche||1 day||7 days||14 days|
The likely objective of an auction participant would be to maximize its uncollateralized auction line. Further, a participant may also desire to use this available line for the longest term possible. In addition, it is possible that auction participants may price collateralized and uncollateralized deposits differently. To this extent how will the bidding process operate? Specifically, the outcome of one tranche may effect the price a participant is willing to bid for a subsequent tranche(s). Will all tranche bids be required at one time (current process) or could each tranche be done independent of one another? That is, an auction for a specific tranche would be completed (with results known and published) before a subsequent tranche(s) is conducted. This will allow participants to incorporate first tranche results into subsequent tranche auctions. Cash managers would like to explore the bidding and collateralized/uncollateralized allocation framework further with you.
The probability of a transaction failing will increase as the auction "repo" will be just another link in the chain. Any break in the chain could have a domino effect, and therefore the risk of the auction transactions failing will increase. As the number of transactions (or pieces of collateral used) increases, the probability of a transaction failing also increases.
The cash managers committee would suggest a session with the Bank of Canada and Department of Finance may be valuable to discuss the operational issues and questions identified.
If the collateral to be used to secure the auction winnings is currently employed to support other payment and settlement activities, the proposed program will drain collateral; hence liquidity. Bidders will have to hold more unencumbered collateral to support the proposal. To reduce the incremental collateral requirements and related costs we would suggest that consideration be given to increasing the uncollateralized lines under this proposal. In addition, due to the impact of late settlement of the afternoon auction, we would suggest that consideration be given to making this auction totally uncollateralized.
Cash Managers would welcome the opportunity to discuss our comments further. Please contact me at your convenience at (416) 594-8798.
Trevor Gloyn Karen Bailey Per Homer
Treasurer Manager. Funding Senior Treasury Officer
(613) 748-2991 (613) 748-2485 (613) 748-2015
We read with interest the Bank's proposals regarding revisions to the rules for RG term deposit auctions. As a Crown corporation and an active participant in the money markers, we recognize the benefits that the ability to borrow short-term through the RG term deposit auctions may provide to us from time to time. Below we outline some of our comments / suggestions regarding your discussion paper.
1. Our major concern is regarding the requirement for non-deposit taking institutions to post collateral (pp. 7-8). As you are aware, the Financial Administration Act does not allow CMHC or other Crown corporations to post collateral. We would suggest that the Bank amend the rules to explicitly exempt Crowns and other entities whose debt carries the full faith and credit of Canada or whose debt is guaranteed by the Federal government from the collateral posting requirements.
2. Another concern is the requirement for third party credit assessments (pp. 8-9). We would suggest that Crowns and other entities whose debt is guaranteed by the Federal government be exempted from this requirement, as they carry the same credit rating as the Federal government. Similarly, we would also suggest that there should not be a specific credit limit for exposure to these Crowns. However, we do see that you may wish to limit the amount that entity may "win" at any RG term auction, in the interest of competitiveness.
3. What would be the process for tendering bids in the RG term auctions? Would we be required to set up systems to electronically submit bids (i.e. CARS) or would there be another process? What would be the notification process and what details would you release to the public?
4. What form would you want this fixed income security that we are issuing to you to take? As a non-deposit taking institution, we do not provide term deposits. However, we could issue a promissory note or commercial paper on an interest-bearing basis to formalize this transaction.
5. A final operational consideration is that some entities in the new RG term auctions may not be members of LVTS. We would recommend that in this situation a solution similar to Government of Canada securities auctions be used, allowing these entities to settle via an LVTS member.
Please feel free to contact us with any questions or comments.
Senior Vice President, Finance & Payments Policy
Credit Union Central of Canada
Credit Union Central of Canada (Canadian Central), a direct clearing member of the CPA and an LVTS participant, has supported the Receiver General Auction Process (the Auction) for many years. The Auction is an important source of funds for the credit union system as the proceeds from the Auction are flowed up to the provincial central credit unions (the provincial Centrals) and then in turn to member credit unions.
We can understand the federal government's desire to widen participation in the Auction to minimize interest costs. Indeed, we would hope that individual credit unions would be able to access funds directly from the Auction. We also concur with the need to strengthen the management of credit risk.
However, the proposed revisions in their present form would make it very difficult for the credit union system in Canada to continue to participate in the Receiver General Auction. Ironically, while the proposals are intended to expand participation, they would reduce participation by the credit union system.
We are requesting that a number of modifications be made to your proposals, modifications that would allow for the continuing participation in the Auction by the Canadian credit union system. Foremost, we request that a means be found to enable Canadian Central to continue to coordinate access to these funds on behalf of the other parts of the credit union system.
Credit Risk Management Framework
Canadian Central does not maintain credit ratings. Of the provincial Centrals, only Credit Union Central of British Columbia (CUCBC) and Credit Union Central of Alberta (CUCA) have long-term ratings, although Credit Union Central of Saskatchewan (CUCS) has an unpublished long-term rating. Only CUCBC has ratings from two rating agencies. Credit Union Central of Ontario (CUCO) and CUCS each have a single short-term rating. No member credit union has a credit rating. Under your proposal, only CUCBC would be eligible as a participant in the Auction.
Typically, in addition to the Auction, some provincial Centrals borrow on behalf of their member credit unions by issuing commercial paper. There is no requirement placed on the Centrals by the investment community to obtain costly long-term credit ratings to borrow short-term funds and for the most part, only one short-term rating is required. Your proposal to require not only one long-term credit rating, but two, for participants to access short-term money on a fully collateralized basis, is in our view onerous and excessive.
We propose that only one short-term rating be required from an acceptable credit rating agency. Moreover, we suggest that such a rating only be required for an uncollateralized credit line advanced to a deposit taking financial institution. For fully collateralized advances, we see no reason for any credit rating to be required. The security of the collateral replaces the need for a credit rating. After all, we participate in the LVTS without a credit rating but on a fully collateralized basis and the Bank of Canada is comfortable with this arrangement. We would assume that the Government of Canada would lend its funds on the same terms.
We also note that you propose to limit the amount of any credit line given to a regulated deposit-taking institution to a maximum of $500 or $250 million depending on its credit rating. You have not indicated what the criteria will be to determine the amount of the line within each of these ranges. We would like to make sure that the credit union system is not put at a disadvantage to other financial institutions in this regard.
We are concerned that you may only accept Government of Canada securities as collateral. Typically we hold few Government of Canada securities and those that we do hold are usually pledged for LVTS purposes. To assist us in participating we would require that a wide range of securities be accepted as collateral. Moreover, we do not want to be moving securities back and forth to the Bank of Canada each day as this is time consuming and the transaction costs are prohibitive. Rather we would prefer to pledge collateral to the government on a standing basis.
We have some concerns with the afternoon auction. We think the afternoon auction should be reserved for LVTS participants only, as the afternoon auction is the flattening mechanism for LVTS and ACSS balances. The introduction of non-LVTS participants may disrupt the orderly squaring up of LVTS positions. Also, as credit ratings are to be required to participate in the auctions, and Canadian Central doesn't have such ratings, Canadian Central would not be able to participate as an LVTS member, in the afternoon auction.
We would like to arrange for larger credit unions to access the Auction directly, however none of these credit unions have credit ratings. If you accept our argument that credit ratings are not needed if collateral is pledged, and we see no reason for you not to do so, then these credit unions may pledge security and participate in the Auction. On the other hand, should you still require credit ratings, we would request that credit unions be allowed to access the Auction on a collateralized basis provided their provincial Central has the appropriate ratings. This would broaden the participation in the auction, which is one of your goals, without overly compromising the management of credit exposure.
We also would like to be able to coordinate the Auction process centrally, preferably at the national level but at least at the provincial levels. This is to provide for efficiencies in collateral management, the bidding process and the payment of funds. Thus, allowing a provincial Central to bid on account of its member credit unions, would be beneficial and could be accomplished by giving the provincial Central access to more than one account. Of course, each account would have to have the appropriate collateral before a bid would be accepted. We would like to discuss this concept with you at greater length.
The credit union system highly values its ability to access Receiver General Auctions and would like to continue to participate in future Auctions. We have made some reasonable suggestions to modify your proposals to allow for the unique structure of the credit union system. We trust that you will carefully review these and accommodate the changes necessary to ensure the future participation of the credit union system in the Auction.
Once you have considered our comments and prior to finalizing the framework for the Auction, we request a meeting to discuss these issues further. I can be reached at (416) 232-3439 or firstname.lastname@example.org.
Thank you for the opportunity to provide input to your proposals.
La Caisse centrale Desjardins
J'ai pris connaissance récemment des intentions du ministère des Finances et de la Banque du Canada de modifier les règles régissant l'adjudication des dépôts à terme du Receveur général.
1) L'accès sera élargi aux entités menant d'importantes opérations de financement, et les dépôts qui leur seront adjugés devront être garantis si ces dernières ne sont pas des institutions de dépôts.
2) Pour les institutions de dépôts, elles seront autorisées à présenter des offres sans avoir à fournir de garanties, jusqu'à concurrence d'une limite de crédit autorisé; celle-ci sera fonction de la cote de crédit:
ex.: 500 millions $ pour cote AA 250 millions $ pour cote A
La Caisse centrale Desjardins a toujours été un intervenant important dans les dépôts du Receveur général et vous me permettrez en réaction "première" de questionner la pertinence des changements que le gouvernement fédéral et la Banque du Canada se proposent d'effectuer dans l'octroi des dits dépôts.
Premièrement, en quoi le système actuel accessible aux participants au Système de transfert de paiements de grande valeur (STPGV) est-il inefficace au point de vouloir l'élargir à ces derniers? Le gouvernement fédéral et la Banque du Canada sont-ils convaincus d'obtenir de meilleures soumissions?
Quand vous mentionnez que le gouvernement invitera les participants qui transigent d'importantes opérations de marchés monétaires, quels sont les critères et les définitions qui s'appliquent à cette catégorie? Est-ce que cela s'applique aux corporations et aux autres organisations gouvernementales (c'est-à-dire Bell Canada, Caisse de dépôt et placement du Québec, C.N.R., etc.)? Si tel est le cas, est-ce que c'est l'intention du gouvernement fédéral de jouer le rôle des banques en "accordant une marge de crédit collatéral" à ces participants? Pourquoi limiter les participants à ceux qui ont une cote de crédit "BBB", quand ces derniers vont nantir leurs emprunts et éliminer ainsi tous les risques?
Deuxièmement, les adhérants de l'Association Canadienne des paiements (ACP) ont un rôle majeur à assumer dans le règlement des transactions financières au pays. Ils se sont adaptés au nouvel environnement de compensation électronique et ont accepté que les nouveaux intervenants au système STPGV aient également accès aux dépôts du Receveur général. Compte tenu de leurs responsabilités qui en font un rouage essentiel dans la mécanique des paiements, pourquoi les participants ne pourraient-ils pas être seuls à avoir accès aux dépôts du Receveur général?
Troisièmement, le système actuel permet aux participants de soumissionner jusqu'à 2,5 fois le produit du ratio des dépôts de l'ACP et ne détermine pas un montant maximal dans les montants adjugés. La Banque du Canada semble soucieuse du risque de crédit qui en résulte et exigera dorénavant des garanties pour des montants qu'elle juge trop élevés. Y a-t-il des raisons de croire que le risque bancaire est devenu plus élevé pour que la Banque du Canada se montre plus sévère? En admettant que cela soit le cas, nous estimons que les montants susmentionnés sont trop bas par rapport au risque que représentent des dépôts d'échéance de 1,2... 7 jours.
On suggère que les montants devraient être doublés considérant les risques de crédit et les courts termes des emprunts, soit: 1 milliard $ pour cote AA
500 millions $ pour cote A
Quatrièmement, le gouvernement considérera les évaluations de crédit effectuées par deux agences de notation reconnues. Si une institution est cotée par quatre ou cinq agences de notation, lesquelles évaluations s'appliqueront? Est-ce que l'agence de notation canadienne sera favorisée?
En dernier lieu, les problèmes opérationnels que vous évoquez relativement aux garanties que nous aurons à fournir le cas échéant, en après-midi principalement, sont réels. Et un processus de règlement à deux volets nous rend perplexes. Nous avons peine à nous acclimater au système dual de paiements, les effets de dislocation sont occasionnellement élevés, alors pourquoi rendre le processus de règlement des dépôts du Receveur général plus complexe?
En résumé, le statu quo nous convient et les modifications proposées, si acceptées, nous compliqueraient la tâche et nous priveraient d'un léger avantage concurrentiel, lequel croyons-nous constitue une rétribution pour le rôle que nous assumons dans le système de paiements du Canada. De plus nous trouvons que les bénéfices que le gouvernement fédéral peut obtenir de ces changements ne justifient ni le coût supplémentaire de l'implantation du système, ni la complexité et l'inconvénient que cela causera aux participants existants.
En espérant que nos préoccupations seront prises en considération, je vous prie d'agréer l'expression de mes sentiments distingués.
Martin Ouellet Mike Edey
Vice-president Treasury Managing Director
National Bank of Canada,
National Bank Financial
National Bank of Canada and National Bank Financial have reviewed the proposed changes to the auction of Receiver General term deposits as outlined in the discussion paper dated 18th July 2000. We understand the government's needs to adapt its current practice to the standard of other G-7 central banks. We appreciate the opportunity to comment on the proposed revision.
In general, as they are now expressed, we estimate that these changes will have a significant impact on the way cash and collateral is managed in the Canadian market, and that it will increase cost and reduce flexibility of doing so.
1. Broadening of market participants.
To the extent that activities in the account of the Receiver General is part of the open market operation of the central bank, the inclusion of non-CPA members in the bidding process may limit the effectiveness of this operation, with respect to its impact on liquidity in the Canadian system. It increases the potential for dislocation between LVTS participants.
2. Collateral, and imposition of limits for uncollateralized deposits.
2.1 The proposed uncollateralized limits seem rather small, considering the size of the Canadian market, and the importance of National Bank in the Canadian payment system. We feel that a $1.0 billion line would be more appropriate.
2.2 Because of the increased demand for collateral, the cost for collateral is likely to increase significantly. For that reason, we welcome the government's suggestion to widen the list of acceptable collateral. However, it is our view that this would not have the expected positive impact, unless all collateral can be delivered electronically for same day value (i.e. CDS and BBS). We feel that doing otherwise would put the payment system at risk of bottleneck.
2.3 We do not think that it is appropriate to set uncollateralized limits based strictly on rating agencies. Although we appreciate that credit quality is an important criteria when it comes time to make investments, we feel that the Bank of Canada should be flexible. In doing so, the Bank should consider the commitment to the Canadian financial market of the institution.
Considering National Bank of Canada and National Bank Financial's market share and commitment to the Canadian money market, it is important that the bank's ability to compete for the uncollateralized lines not be compromised by other institutions with a higher credit rating and less commitment to the money market.
2.4 As we understand the proposed changes, it seems that collateralized deposits will attract double collateralization; not only collateral is needed to support the deposits but collateral is also needed for reimbursement of the deposit via LVTS * tranche 1.
2.5 We currently use our inventories as collateral to finance our cash requirements. The type and scope of collateral the Bank of Canada will accept is important to our financing. Our collateral is extensive and consists of many small positions of BAs, Commercial Paper, Asset-Backed C.P., Coupons, Municipals bonds, Corporate Bonds, Provincials and Canadas. It is important that the Government considers these as acceptable collateral, and is open to receive them in small blocks.
2.6 Another concern is the margining of the acceptable collateral. The Bank of Canada currently takes a margin on collateral pledged on PRA, unlike Repo which prices collateral at current market and prices the exposure on a market-to-market margin. There could develop a situation whereby a large collateral exposure to the government would result in a significant cash requirement due to the margin (i.e. 5%), therefore increasing our costs of financing.
2.7 With regard to the Government reviewing the idea of a third party to manage collateral and settlements, it is our view that, although there are third parties that can handle these types of transactions in a very efficient manner, we are concerned of the costs involved. These costs, including settlement and substitution fees, raise the question of who would absorb the said costs and whether these fees become too price prohibitive to efficiently finance ourselves.
2.8 Settlement of morning auction through CDS (at 4 p.m.) could cause intra-day liquidity impact; the collateral being tied up at the time we have to settle our tax remittances (at 3 p.m.).
Please feel free to contact us if you need clarification or if further discussion is needed.
Manager of Debt Servicing and Financial Risk
Government of Newfounland and Labrador
Department of Finance
Debt Management Division
Recently, the Government of Newfoundland and Labrador became aware of the possibility of changes to the rules pertaining to auctions of Receiver General term deposits, whereby excess cash balances would be auctioned to interested parties meeting the required criteria set forth in the proposed revisions.
Occasionally, the Province of Newfoundland has short-term borrowing requirements which it covers either through the issuance of short-term treasury bills or through the various credit facilities offered by its main banker. Should the Government of Canada make this auction facility available to the provinces, the Province of Newfoundland may have an interest in participating in the auctions. Thus, we ask that the Bank of Canada consider this possibility, and in the event of its consideration, we request more information with respect to the collateralization and minimum credit rating requirements for the provinces.
Heidi H. Chéron
Money market and foreign exchange trader
Ontario Financing Authority Office ontarien de financement
The Receiver General balances auctions are the closest thing to a direct liquidity marketplace that we have in Canada, and the information disseminated in their results is a useful indicator of short-term funding costs. Opening up these auctions to a wider group will make the market more transparent, in addition to allowing you to diversify your credit risk.
As a major participant in the short term funding market, the Ontario treasury would welcome the possibility of participating in the auctions of RG balances. Ontario would use this funding source as a substitute for some of the short term funding currently obtained in the market on both a secured (via the repo market) and an unsecured (via the interbank market) basis.
However, we are concerned about the exclusion of Canadian provinces meeting your credit rating criteria from uncollateralised access to RG balances as a source of funding. Although some provinces, such as Ontario, do operate deposit-taking institutions, use of RG balances as a source of funding would be more pertinent in the provincial treasury operation than in the financial institution branch. Even if the provinces themselves are not directly regulated in the financial arena, provincial borrowers meeting your credit rating criteria present excellent credit risk and would allow diversification beyond the financial system, which does present some systemic risk. In addition, as noted in your discussion paper, collateral cannot be delivered at certain times of the day. For many entities such as Ontario, posting standby collateral is not really workable, because all collateral needs to be ready and available for repo operations if no funding is won at the RG balances auction.
I hope that the above observations will be useful in the final formulation of your new procedures and policies.
Andrew G. Scace
Head of RBC DS Global Markets
RBC Dominion Securities Inc.
Toronto, Ontario, CANADA M5J 2W7
Thank you for the opportunity to provide our comments on the proposed revisions to the auction rules pertaining to Receiver General Term Deposits. We have outlined the issues we feel require further discussion below. We understand the Cash Management Subcommittee of the CBA will be providing comments to you also with respect to the operational implications of the proposed changes on the payments and securities settlement systems. We will direct our operational concerns through that forum.
As discussed when you met with our Funding group personally, the Government's successful efforts to reduce the deficit and pay down debt have made government collateral increasingly expensive. Should the Receiver General restrict itself to government collateral we expect that the return to the government on these funds would be sharply reduced. This is especially true for terms greater than overnight. As your paper points out, the Federal reserve receives 25 basis points below Fed Effective. Were the list of acceptable collateral expanded along the lines put in place for Y2K, this loss of return would be somewhat mitigated.
A broader range of collateral imposes some additional credit concerns. If the Receiver General were to restrict Royal Bank to a $500 million credit facility, how would the receipt of Royal Bank paper as collateral from another participant impact our facility? How would the government impose any kind of credit limits without disclosing what credits it might be open on?
As bidders, where there are multiple tranche auctions, how will the unsecured portions be allocated across tranches? Will bidders submit unsecured and secured bids? Where a bidding institution has pledging limits, how will a bidder be able to manage within their pledging limit if they do not know what they will win. This implies that total bids submitted cannot exceed the available pledging authority. We believe that this could potentially reduce auction coverage.
This is also true for collateral availability in general. We currently bid for our full limit and there are no repercussions if we are allocated more than we require, we simply lend it to another counterparty. Under the proposed plan, our total bids cannot exceed the amount of collateral we have available which may also reduce auction coverage.
In our opinion, collateral is too scarce and expensive to tie up with a standing pledge. This is particularly true if the Bank of Canada imposes operational constraints on changing the amount or composition of the collateral pledged.
We are also concerned that these potential reductions in coverage put LVTS participants at a disadvantage. Where auctions are not currently taken up, the system is left short. This leaves LVTS participants scrambling to cover short positions resulting from others' inaction. In order to avoid being left short, LVTS participants would have to bid the afternoon auction, a requirement that would not be forced on others with access to RG auctions.
We find the proposed credit limit inadequate for an institution of our size, creditworthiness and degree of market participation. We suggest you consider benchmarking the proposed limit against the typical credit limits Schedule I banks have for each other and for large multinational banks. In addition, your comments on credit refer to credit rating exclusively with no mention of the capital base of the borrowing institution. How would you propose to evaluate the credit limit of institutions with multiple deposit taking entities? What constitutes significant domestic money market operations? Would you consider Royal Bank, Royal Trust Corporation, Royal Trust Company and Royal Bank Mortgage Corporation as a single deposit taking institution or four as CDIC does?
We believe the current system is very efficient and that the returns received by the Government (at least for the morning auction) are very fair, usually within 1-2 basis points of the Bank of Canada's stipulated overnight target rate. As such, we see very little room for improvement in overall returns to the Government. We do agree that it is appropriate for the Government to create a credit management framework, which includes single name limits, although as we mentioned, $500 million is too low to manage the Government's balances effectively.
In conjunction with this discussion, the Government might also wish to consult the industry on means of reducing the size of the range of Government balances. More frequent use of other cash management tools like regular and same day cash management auctions might reduce the need for the Government to build up such large cash balances. We noted with interest the Government's interest in discussing the purchase of short bonds for cash management purposes and would support this initiative, especially for very short bonds (less than 3 months remaining to maturity). To some extent we have the Government holding larger than desired cash balances in order to keep the T-Bill tender sizes up. Perhaps it is time to revisit the T-Bill auction structure again. As more benchmark bond issues roll into the money market area of the curve, the one-year auctions could be reduced to monthly tenders or perhaps eliminated entirely.
In summary, we believe the proposed unsecured credit limit is insufficient for our needs as well as our ability to respond to the Receiver General's needs. There are also very real collateral management and credit risk management impediments to these proposals, which may reduce the Government's returns significantly. In our opinion, revisiting the Government's cash management requirements with a view to reducing excess balances, combined with more market friendly unsecured limits would allow the Government greater control over credit exposure without undue impact on returns.
Jeremy S.T. Farr
Borden Ladner Gervais LLP
On behalf of our client, an investment dealer in Canada, we are pleased to submit the following comments in response to your July 2000 discussion paper entitled "Proposed Revisions to the Rules Pertaining to Auctions of Receiver General Term Deposits".
The idea of expanding access to the auctions to a wider list of institutions is welcomed for reasons of diversification of risk and also to enhance the returns on the Canadian government's cash balances. However, some of the proposed elements warrant comment.
We propose to discuss these subjects from the perspective of an investment dealer which is a non deposit-taking institution and a primary dealer for Government of Canada marketable bonds.
Our client believes that access to auctions of cash balances should be restricted to participants in the financial industry, i.e. Canadian Payments Association ("CPA") members, Large Value Transfer System ("L VTS") members, primary dealers, as well as provincial governments and large Crown corporations.
Access to such auctions has in the past been limited to the main players in the Canadian banking scene, namely members of the CPA and the LVTS. The idea of further expanding the list is welcomed. It is logical and natural to include primary dealers (the Government of Canada's main partners in securing the government's borrowing needs) in the list of institutions. Indeed, primary dealers of Government of Canada bonds have many responsibilities. These include, among others, the distribution of securities (primary market) and market making (secondary market). The Government of Canada establishes these responsibilities for primary dealers with no remuneration given for distributing the securities. Institutional investors have also been granted permission to do opportunistic buying at Government of Canada bond auctions with no responsibilities associated with this process.
In the past, the government has naturally favoured deposit-taking institutions. Now, with the treasury operations of some investment dealers having been merged with that of their parent bank, these parties have benefited from this situation although they are not deposit-taking institutions. These investment dealers are primary dealers of the federal government. It is felt at this time that the remaining primary dealers should be included as well.
One important group of participants in the financial markets has been omitted from the list of candidates for these auctions, namely the provinces and large Crown corporations (for example, CMHC, EDC, Farm Credit Corporation, Hydro-Québec, Newfoundland & Labrador Hydro). For their short-term borrowing needs, they rely on their treasury bill and commercial paper programs as well as bank lines of credit. This group constitutes excellent candidates to have access to these auctions and they are well known to the federal government.
Going further by giving access to the non-financial sector as contemplated by Proposal is a way of disintermediating the market. Financial disintermediation in this context means federal government cash balances being lent directly to corporations and bypassing the financial institution altogether, rather than such balances being deposited at a financial institution which in turn lends on the deposits. Should this be an initiative led by the federal government? We understand that the federal government strives for maximum returns for Canadian taxpayers. However, leading the Canadian financial scene towards market disintermediation is a responsibility that should be left to the financial markets.
By lending directly to corporations, the federal government could also expose itself to political attacks. Media and others could wrongly accuse the federal government of favouring specific companies or industries.
By allowing access only to participants from the financial sector (i.e. CPA and LVTS members and primary dealers) as well as provinces and large Crown corporations, to the exclusion of the non-financial sector which includes finance companies and other entities involved in credit extensions, the counterparties to the federal government ensure a more liquid balance sheet should difficulties arise, for example, during times of economic uncertainty.
Our client believes it is more important to have liquid collateral and margins than credit ratings.
The federal government has proposed to use credit ratings as a requirement to participate in these auctions. Candidates must have two credit ratings from recognized agencies, most probably CBRS and DBRS. While LVTS members have credit ratings from DBRS and CBRS, some CPA members do not have credit ratings from these two agencies and the government could have entered into transactions with these parties over time without any unfortunate incident and without collateral.
Should the federal government give access to the non-financial sector, again the government is favouring access mainly to parties that are public entities and are disfavouring privately-owned corporations. In Canada, when a firm is held privately, it limits the publication of its financial information and does not usually seek credit ratings from recognized credit agencies.
Investment dealers owned by banks do not have their own credit rating (it is embedded in the credit rating of their parent organization). However, the treasury functions of bank-owned dealers and their parent bank have been merged so that funds needed by the dealer are lent by the parent bank. Therefore, these dealers have access to funds without providing either a credit rating or collateral.
As part of financing their operations, investment dealers are involved in repo transactions. Investment dealers set up credit limits with counterparties involved. In order to establish these limits, audited balance sheets must be submitted to the dealer by the counterparty and credit ratings are not required by the dealer. Should the financial health of a counterparty not be satisfactory to an investment dealer's management, collateralized transactions will not be entered into with this counterparty. We suggest the same approach be used by the federal government in the auction process.
Furthermore, although credit agencies provide good financial analysis, they can be slow at times in reacting to particular situations. For example, the financial situations of Confederation Life, Royal Trust, Olympia & York and Newcourt Credit Group had significantly deteriorated before the credit rating agencies re-evaluated their ratings. Although the government does not have the skills to give credit ratings, it can perform some financial analysis based on important financial criteria just as is done by financial market participants. Obviously, the government is concerned with credit risk but having collateral diminishes the risk involved in an important way.
If the federal government wishes to maintain wide inclusion of candidates that can have access to its cash auctions, we would suggest that a minimum credit rating of BBB is barely acceptable. In the investment industry, investment grade securities have a credit rating of BBB (Low) or higher but an important number of institutional investors have an A credit rating threshold. As stated above, although you may rely on credit ratings, the timing of re-evaluation of ratings by the credit agencies could be problematic for the government.
Finally, if, as suggested, candidates are limited to banks, primary dealers, provincial governments and large Crown corporations, are credit ratings really needed in such cases?
With respect to the non-financial sector, however, which is not as well known to the federal government as the foregoing group, our client suggests that higher credit ratings be considered if accepting corporate credits as collateral. Again, A should be the minimum acceptable credit rating. On the other hand, our client believes that provincial credits should be accepted as collateral even if the credit rating is BBB. A BBB provincial credit is stronger than both an A municipal or corporate credit rating.
All in all, opening access to these auctions to the significant players in the domestic financial markets is worthy of praise. It should be remembered that participants in financial markets provide liquid balance sheets which is an important element in assessing their credit worthiness. Credit ratings are an interesting criteria but far less important than having collateral and margins. The inclusion of the non-financial sector can result in less liquid balance sheets for the counterparties and reliance on credit ratings can be troublesome as proven in the recent past.
Our client thanks you for the opportunity to provide comments on such an important subject.
Peter G. Copestake
Vice-President & Treasurer
I am writing this letter in response to your request for comments on the Bank of Canada's proposed changes to the Receiver General term deposit auction rules.
The opening up of the Receiver General term deposit auction to include institutions beyond those presently approved for the Large Value Transfer System (LVTS) is an important opportunity for the Receiver General to diversify its counterparty credit exposures. Federally regulated life insurance companies, such as Manufacturers Life Insurance Company (MLI) and its wholly owned subsidiary Manulife Bank (MBC), have historically been excluded from LVTS. The inclusion of MLI and MBC with their strong credit ratings and excellent liquidity profile will bolster the federal government's direct access to high quality counterparties. From Manulife's perspective, the ability to bid on receiver general deposits is an opportunity to diversify funding sources.
Although we are pleased with the proposal to open up the Receiver General term deposit auction process, we do have concerns regarding the proposed collateral requirements and borrowing limits that would apply to Manulife.
We feel strongly that MLI should receive the same treatment as the major Chartered Banks in respect of collateral requirements and borrowing limits. Manulife's liability and credit ratings exceed those of all of the Canadian Chartered Banks. In addition, MLI's superior liquidity profile, and the fact that insurers are not significant debt issuers, is supportive of the argument that Manulife's access and collateral requirements should be on par with that of the five major Chartered Banks. Some other new term deposit bidders may appropriately be subject to the proposed new collateral requirements but leading institutions such as MLI and MBC should not be capriciously subjected to different administrative treatment in this matter. As such, we recommend that the Bank of Canada reconsider the inclusion of federally regulated life insurance companies within the uncollaterized program by expanding its list to include federally regulated life insurance companies. Manulife Financial and Manulife Bank should be able to bid on uncollateralized balances on the same terms as other deposit taking institutions.
The following table summarizes our comments with respect to the Receiver General term deposit auction process.
Receiver General Term Deposit - Comments
|1||Access to federal government cash balance auction would be broadened. The government invites expressions of interest from parties with significant Canadian dollar wholesale funding operations that might want to participate.||Agree||Manulife is in favour of the broadening of the participants that can bid on Receiver General deposits and would like to participate.|
|2A||Access for non deposit-taking institutions will be on a fully collateralized basis.||Disagree||Manulife strongly disagrees with the exclusion of federally regulated insurance companies from bidding on an uncolleralized basis. Manulife's ratings exceed or are on par with most deposit taking institutions. We feel that the Receiver General would be disadvantaged by excluding insurance companies from the process. In addition, life insurance companies offer short-term deferred annuities, which are similar as Bank term deposit products. Deferred annuities are in substance equivalent to bank term deposits in that both offer a fixed rate of interest for a specified term and rank senior to debt borrowings.|
|2B||Non-deposit taking institutions must have a minimum credit rate (a long term rating of BBB or equivalent).||Agree||No additional comments|
|3||Deposit-taking institutions operating and regulated in Canada with acceptable minimum credit rating (a long term rating of A low or equivalent) would be allowed to bid up to authorized credit limits on an uncolleralized basis. For all deposits above authorized credit limits, bidders would be required to provide collateral.||Agree
With wording change
|As per 2A, Manulife recommends that the following be inserted after Deposit-taking institutions:
"and federally regulated Insurance Companies (or financial institutions)"
Manulife's subsidiary Manulife Bank should be treated as the same credit as Manulife Financial.
|4||Long-term credit ratings provided by third party credit agencies would be the basis of credit assessments. The government would require two credit ratings.||Agree||No additional comments|
|5||The government will review the bidding limits that would apply under the new framework.||Agree||Manulife agrees that bidding limits should be reviewed and revised. The review should appropriately reflect the credit worthiness of new entrants that are non-deposit taking institutions.|